Factor endowments and the heckscher ohlin theory (chapter 5)

Factor endowments and the heckscher ohlin theory (chapter 5)

1. WELCOME TO OUR PRESENTATION

2. PRESENTED TO: AYESHA AKHTER ASSISTANT PROFESSOR DEPARTMENT OF FINANCE JAGANNATH UNIVERSITY PRESENTED BY: GROUP-04

3. GROUP: 4 SL NO. ROLL NAME   B-120203032 RAJIB HUSSAIN 2.   B-120203034 ASIBUL ISLAM MILU 3.   B-120203043 TAJRIMA SULTANA SRISTI 4.   B-120203045 MOHAMMAD WASHIM 5.   B-120203047 RASEL AHAMED 6.   B-120203055 SUJAN BHUIYAN 7.   B-120203071 GAZI RAFSAN SHAHAB 8.   B-120203137 AFRIN KHAN 9.   B-110203091 EHSUN HOQUE

4. CHAPTER 5 FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN THEORY

5. RASEL AHAMED ID: B-120203047

6. In this chapter : Introduction Assumptions of the Theory Factor Intensity, Factor Abundance, and the Shape of the Production Frontier Factor Endowments and the Heckscher-Ohlin Theory Factor-Price Equalization and Income Distribution Empirical Tests of the Heckscher-Ohlin Model

7. Introduction In this Chapter, we extend our trade model in order to identify one of the most important determinants of the difference in the pretrade -relative commodity prices and the comparative advantage among nations. This also allows us to examine the effect that international trade has on the relative price and income of the various factors of production . Our trade model so extended is referred to as the Heckscher–Ohlin model.

8. 5.2 Assumptions of the Theory The Assumptions There are two nations (1&2), two commodities (X&Y), two factors of production (labor & capital). Used to illustrate the theory in a two-dimensional figure. Both nations use the same technology in production. Means both nations have access to and use the same general production techniques. Commodity X is labor intensive and Y is capital intensive in both nations. Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the same relative factor prices.

9. Both commodities are produced under constant returns to scale in both nations. Means that increasing the amount of L and K will increase output in the same proportion There is incomplete specialization in production in both nations. Means that even with free trade both nations continue to produce both commodities. This implies neither nation is very small. Tastes are equal in both nations. Means demand preferences are identical in both nations. When relative prices are equal in the two nations, both consume X&Y in the same proportion.

10. There is perfect competition in both commodities and factor markets in both nations. Means that producers, consumers, and traders of X&Y in both nations are each too small to affect prices of commodities. Also, in the L-R commodity prices equal their costs, leaving no economic profit . There is perfect factor mobility within each nation but no international factor mobility. Means K&L are free to move from areas and industries of lower earnings to those of higher earnings until earnings are the same in all areas, uses and industries of the nation. International differences in earnings persist due to zero international factor mobility in the absence of international trade.

11. There are no transportation costs, tariffs, or other obstructions to the free flow of international trade. Means specialization in production proceeds until relative (and absolute) commodity prices are the same in both nations with trade. If transportation costs and tariffs were allowed, specialization would proceed only until prices differed by no more than the costs and tariffs on each until of the commodity traded. All resources are fully employed in both nations. Means there are no unemployed resources in either nation. International trade between the two nations is balanced. Means that the total value of each nation’s exports equals the total value of the nation’s imports.

12. Comment On the basis of these assumes, the Heckscher-Ohlin theorem predicted that the capital surplus country specializes in the production and exports of capital intensive goods, and the labor surplus country specialize in the production and exports of labor intensive goods.

13. MOHAMMAD WASHIM ID: B-120203045

14. 5.3 Factor Intensity, Factor Abundance, and the Shape of the Production Frontier (PF) Factor Intensity In a world of 2 commodities and 2 factors, Y is capital intensive if its (K/L) is greater than (K/L) of X. If production of Y requires 2K and 2L, then K/L=1. If production of X requires 1K and 4L, then K/L=1/4. We say that Y is K intensive and X is L intensive. Measuring K and L intensity depends on K/L rather than the absolute amount of K and L. In fig. 5-1, Nation 1 can produce 1Y using 2K-2L, and 2Y using 4K-4L. Thus, K/L=1, this gives the slope of Y in Nation 1.

15. FIGURE 5-1 Factor Intensities for Commodities X and Y in Nations 1 and 2. Nation 1 can produce 1X using 1K-4L, and 2X using 2K-8L. Thus, K/L=1/4, this gives the slope of the ray of X in Nation 1. In Nation 2, K/L=4 for Y and 1 for X.

16. FIGURE 5-1 Factor Intensities for Commodities X and Y in Nations 1 and 2. Therefore, Y is the K-intensive commodity, and X is the L-intensive in Nation 2 also. This is shown by the fact that the ray from the origin for good Y is steeper than that of X in both nations.

17. FIGURE 5-1 Factor Intensities for Commodities X and Y in Nations 1 and 2. Even though Y is K-intensive relative to X in both nations, Nation 2 uses a higher K/L than Nation 1. For Y, K/L=4 in Nation 2 but K/L=1 in Nation 1. For X, K/L=1 in Nation 2 but K/L=1/4 in Nation 1.

18. B. Factor Abundance Two ways to define factor abundance: 1) In terms of physical units (i.e. overall amount of K&L (TK/TL) available to each nation). According to this definition, Nation 2 is capital abundant if the ratio of total amount of capital to total amount of labor available in Nation 2 is greater than that in Nation 1. The ratio of TK/TL what is important , not the absolute amount of K&L available in each nation. Thus , Nation 2 can have less K than Nation 1 and still be the capital abundant nation if TK/TL in Nation 2 exceeds TK/TL in Nation 1.

19. 2) I n terms of relative factor prices (i.e. rental price of K (P K ) and the price of L time (P L ) in each nation). According to this definition, Nation 2 is K abundant if (P K /P L ) is lower in Nation 2 than in Nation 1. Since rental price of K is taken to be the interest rate (r) and the price of labor time is wage (w), then P K /P L = r/w. The ratio r/w what is important , not the absolute level of r that determines whether a nation is K abundant. The first definition considers only the supply of factors, while the second definition considers both demand and supply. The demand of the factor is derived from demand for the final commodity that requires the factor in its production.

20. C. Factor Abundance and the Shape of the Production Frontier Since Nation 2 is K-abundant and Y is K-intensive, Nation 2 can produce relatively more of Y than Nation 1. Since Nation 1 is L-abundant and X is L-intensive, Nation 1 can produce relatively more of X than Nation 2. This gives a production frontier for Nation 1 that is relatively flatter and wider that that of Nation 2.

21. FIGURE 5-2 The Shape of the Production Frontiers of Nation 1 and Nation 2.

22. AFRIN KHAN ID: B-120203137

23. The Heckscher-Ohlin Theory Heckscher-Ohlin (H-O) theory is based on two theorems: 1. The H-O theorem A nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nation’s relatively scarce and expensive factor . In short, the relatively labor-rich nation exports the relatively labor-intensive commodity and imports the relatively capital-intensive commodity. Explains comparative advantage rather than assuming it.

24. For example, if we imagine commodity X is labor intensive commodity and nation 1 produces it, on the other hand nation-2 produces commodity Y which is capital intensive commodity. here L is available and cheap factor in nation 1 and so is K in nation 2. Now H-O Theorem says that, Nation-1 will export X because X is the L-intensive commodity and L is relatively abundant and cheap factor in Nation 1. N ation-1 and Nation-2 will export Y because Y is the K-intensive commodity and K is relatively abundant and cheap factor in Nation 2. Nation-2

25. FIGURE 5-3 General Equilibrium Framework of the Heckscher -Ohlin Theory. 1 . The tastes and the distribution in the ownership of factors of production together determine the demand for commodities . 2. The demand for commodities determines the derived demand for the factors required to produce them. General equilibrium framework of the H-O Theory

26. FIGURE 5-3 General Equilibrium Framework of the Heckscher -Ohlin Theory. 3 . The demand for factors of production, together with the supply of factors, determines the price of factors of production under perfect competition. 4.The price of factors of production, together with technology , determines the price of final commodities . 5.The difference in relative commodity prices between nations determines comparative advantage and the pattern of trade.

27. Figure 5.3 shows clearly how all economic forces jointly determine the price of final commodities. This is what is meant when we say that the H–O model is a general equilibrium model. However , out of all these forces working together, the H– O theorem isolates the di f ference in the physical availability or supply of factors of production among nations to explain the di f ference in relative commodity prices and trade among nations. Specifically, Ohlin assumed equal tastes among nations. General equilibrium framework of the H-O Theory

28. GAZI RAFSAN SHAHAB ID: B-120203071

29. C. Illustration of the Heckscher -Ohlin Theory Since the two nations have equal tastes, they face the same indifference map . Indifference curve I is the highest IC that Nation 1 and Nation 2 can reach in isolation, and points A and A / represent their equal. points of production and consumption in the absence of trade. The tangency of IC I at points A and A / defines the no-trade equal-relative commodity prices of P A in Nation 1 and P A/ in Nation 2. Since P A < P A/ , Nation 1 has a com-adv. in X and Nation 2 has a com-adv. in Y.

30. FIGURE 5-4 The Heckscher -Ohlin Model. C. Illustration of the Heckscher -Ohlin Theory The right panel shows that with trade Nation 1 specializes in X and Nation 2 in Y. Specialization continues until Nation 1 reaches point B and Nation 2 B / , where the transformation curves are tangent to the common relative price line P B .

31. FIGURE 5-4 The Heckscher -Ohlin Model. C. Illustration of the Heckscher -Ohlin Theory Nation 1 exports X in exchange for Y and consume at point E on IC II. Nation 2 exports Y for X and consume at point E / (which coincides with point E). Note that Nation 1’s exports of X equal Nation 2’s imports of X (i.e. BC=C / E / ). Similarly, Nation 2’s exports of Y equal Nation 1’s imports of Y (i.e. B / C / =C E).

32. FIGURE 5-4 The Heckscher -Ohlin Model. C. Illustration of the Heckscher -Ohlin Theory At P X /P Y > P B , Nation 1 want to export more of X than Nation 2 wants to import at this high relative price, and P X /P Y falls towards P B . At P X /P Y < P B , Nation 1 want to export less of X than Nation 2 wants to import at this low relative price, and P X /P Y rises towards P B .

33. FIGURE 5-4 The Heckscher -Ohlin Model. C. Illustration of the Heckscher -Ohlin Theory Point E involves more of Y but less of X than point A However, Nation 1 gains from trade because E is on higher IC II. Similarly, at E / which involves more X but less Y than A / , Nation 2 is better of because E / is on higher IC II.

34. TAJRIMA SULTANA SRISTI ID: B-120203043

35. 5.5 Factor-Price Equalization and Income Distribution The factor price equalization theorem International trade will bring about equalization in the relative and absolute returns to homogenous factors across nations. In short, wages and other factor returns will be the same after specialization and trade has occurred. Holds only if H-O theorem holds.

36. 5.5 Factor-Price Equalization and Income Distribution The factor price equalization theorem International trade causes w to rise in Nation 1 (the low-wage nation) and fall in Nation 2. (the high-wage nation), reducing the pre trade difference in w between nations . Similarly, trade causes r to fall in Nation 1 (the K-expensive nation) and rise in Nation 2. (the K-cheap nation), reducing the pre trade difference in r between nations. Thus, international trade causes a redistribution of income from the relatively expensive (scarce) factor to the relatively cheap (abundant) factor.

37. FIGURE 5-5 Relative Factor–Price Equalization. Relative and Absolute Factor-Price Equalization Factor Price equalization Theorem The horizontal axis measures w /r and the vertical axis P X / P Y . Before trade, Nation 1 is at point A , with w /r = (w /r ) 1 and P X / P Y = P A while Nation 2 is at point A ` , with w /r = (w /r ) 2 and P X / P Y = P A`. Since w /r is lower in Nation 1 than in Nation 2, PA is lower than PA` so that Nation 1 has a comparative advantage in commodity X.

38. FIGURE 5-5 Relative Factor–Price Equalization. Relative and Absolute Factor-Price Equalization Factor Price equalization Theorem As Nation 1 specializes in the production of commodity X with trade and increases the demand for labor relative to capital, w /r rises. As Nation 2 specializes in the production of commodity Y and increases its relative demand for capital, r /w rises (i.e., w /r falls). This will continue until point B = B` , at which P B = P B` and w /r = (w /r ) ∗ in both nations.

39. FIGURE 5-5 Relative Factor–Price Equalization. Relative and Absolute Factor-Price Equalization Factor Price equalization Theorem PX/PY will become equal as a result of trade, and this will only occur when w/r has also become equal in the two nations (as long as both nations continue to produce both commodities).

40. Comment The Heckscher-Ohlin Theory & Factor Price equalization Theory According to the H–O theorem, a nation will export the commodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factor. According to the factor–price equalization (H–O–S) theorem, international trade will bring about equalization of relative and absolute returns to homogeneous factors across nations.

41. ASIBUL ISLAM MILU ID: B-120203034

42. International trade on the effect of relative factor prices within each nation Trade increases the price of the nation’s abundant and cheap factor and reduces the price of its scarce and expensive factor. W rises and r falls in Nation 1 while w falls and r rises in Nation 2. International trade on the effect of income within each nation. The real income of labor and the real income of owners of capital move in the same direction as the movement in factor prices. Trade causes the real income of labor to rise and the real income of owners of capital to fall in Nation 1 while in Nation 2 the situation is the opposition. 5.5c Effect of International Trade on distribution of Income

43. International trade on the effect of relative factor prices and the distribution of income within each nation in the long run ; According to H-O-S theorem, international trade causes real wages and the real income of labor to fall in a capital-abundant and labor –scarce nation (such as developed countries). On the contrary, international trade causes real interests and the real income of capital to fall in a labor-abundant and capital scarce nation (such as developing countries); Unequal distribution of income needs an appropriate distribution policy of the government. 5.5c Effect of International Trade on distribution of Income

44. EHSUN HOQUE ID: B-110203091

45. 5.5 Factor-Price Equalization and Income Distribution 5.5D Specific Factors Model Trade will: have an ambiguous effect on a nation’s mobile factors, benefit the immobile factors specific to a nation’s export commodities or sectors, and harm the immobile factors specific to a nation’s import-competing commodities or sectors.

46. Specific Factors Model In the short run when some factors may be immobile Or specific to some industry or sector. In this case, it Assumes that trade will have an ambiguous effect on the nation’s mobile factors : It will benefit the immobile factors that are specific to the nation’s export commodities or sectors, and harm the immobile factors that are specific to the nation’s import-competing commodities or sectors.

47. Specific Factors Model In the long run when all input are mobile among all Industries of a nation, the H-O model postulates that the opening of trade will lead to an increase in the real income or return of the inputs used intensively in the nation’s export sectors and to a reduction in the real income or return of the inputs used intensively in the production of the nation’s import-competing sectors.

48. RAJIB HUSSAIN ID: B-120203032

49. 5.6 Empirical Tests of the H-O Model 5.6 A. The Leontief Paradox (1) Empirical test by Wassily Leontief (1951) Data : U.S. data for the year 1946 . Hypothesis : Since the U.S. was the most K-abundant nation in the world, it was expected that the U.S. exported K-intensive commodities and imported L-intensive commodities . Test method: Calculated the amount of labor and capital in a ‘representative bundle’ of $1 million worth of U.S. exports and import substitutes for the year 1947. - Result : U.S. import substitutes were more K-intensive than U.S. exports .  This is called the Leontief paradox.

50. Empirical Tests of the Heckscher -Ohlin Model Source of the Leontief Paradox Bias Assumed a two factor world which required assumptions about what is capital and what is labor. Most heavily protected industries in U.S. were L- intensive, reduced imports and increased domestic production of L-intensive goods. Only physical capital included as capital, ignoring human capital (education, job training, skills).

51. 5.6 Empirical Tests of the H-O Model Implications of the conflicting empirical results The H-O model is useful in explaining international trade in raw materials, agricultural products which is large component of trade between developing and developing countries.

52. Explanations of the Leontief Paradox The used data was not representative; Two-factor model (L, K) , ignoring the natural resources; (Many production process using natural resources) U.S. Trade policy (heavy protection of domestic labor-intensive industries, so more labor –intensive goods export); Only the measure of physical capital and ignoring the human capital and “knowledge” capital; At the same time there are many strong and convincing evidences verifying H-O theory.

53. Comment The first empirical test of the H–O model was conducted by Leontief using 1947 U.S. data. Leontief found that U.S. import substitutes were about 30 per- cent more K intensive than U.S. exports. Since the United States is the most K -abundant nation, this result was the opposite of what the H–O model predicted ; this became known as the Leontief paradox. Empirical results seem to show that the traditional Heckscher–Ohlin model can explain trade between developed and developing countries (often referred to as North–South trade) and a highly qualified or restricted version of the H–O can model the much larger trade among developed countries (i.e., North–North trade).

54. SUJAN BHUIYAN ID: B-120203055

55. 5.6C Factor-Intensity Reversal Factor-intensity reversal refers to the situation where a commodity is L intensive in the L-abundant nation and K intensive in the K -abundant nation. This may occur when the elasticity of substitution of factors in production varies greatly for the two commodities. With factor reversal, both the H–O theorem and the factor–price equalization theorem fail. Some tests show that factor reversal was fairly prevalent, some tests provide strong confirmation of the H-O model.

56. 5.6C Factor-Intensity Reversal In the absence of factor intensity reversals, the Heckscher-Ohlin theorem is valid on the basis of the price definition of factor abundance. The identity of tastes between countries is unnecessary to assume in this case. In the absence of factor intensity reversals, the Heckscher-Ohlin theorem is true on the basis of the physical definition of factor abundance only if the tastes are homogenous and similar between countries . In the presence of factor intensity reversals, the Heckscher-Ohlin theorem is not generally valid.